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Fed Tax Fall 2020 Outline
What constitutes GI?
What’s deductible from GI?
When is an item included or deductible?
What is the character of the item?
To whom is item attributable?
Chapter 1: Introduction
I.
II.
*will be on final exam
Progressivity*
a. Tax = Base x Rate
b. Base = Taxable Income
c. Rate = Given percentage, on the progressive scale
1. Flat rate = rate stays the same, proportional, doesn’t raise enough revenue.
2. Progressive rate (our system) = rate increases with TI.
i.
Marginal = rate at which last dollar of income is taxed.
ii.
Effective = more like the average rate.
iii.
Only the last dollar is taxed at highest rate; still get benefit of lower rates for income
at those levels.
3. Example: Unmarried individual’s TI for 2020 is $173,300. Tax liability?
i.
Rev. Proc. 2019-44, § 3.01, Table 3 pg. 1855 = If TI over 163,300 but not over 207,350
= 32% marginal bracket.
ii.
Tax = 32,271.50 + 32% (173,300 – 163,300)
iii.
Tax = 32,271.50 + 32% (10,000)
iv.
Tax = 32,271.50 + 3,200
v.
Tax = 36,471.40
a. Marginal rate = 32%
b. Effective rate = Total tax/TI = 36,471.50/173,300 = .2104 = 21%
d. Moodle sample probs
Policies*
a. Equities
1. Horizontal = same income level.
i.
Example:
a. A lives alone, earns $100.
b. B has 4 kids, supports parents, earns $100.
i. Taxing A & B differently violates horizontal equity.
2. Vertical = different income level.
i.
Example:
a. A is single, lives alone, earns $100.
b. B is single, lives alone, earns $100,000.
i. Taxing A & B differently violates vertical equity.
b. Complexity
1. Takes more time & expense to comply w/ complex rules.
2. Competing policy to equity (decrease complexity can increase inequity).
3. Progressive rates drive income shifting.
4. Preferential rates for capital gains drives complex rules for LTCG.
c. Economic impact/efficiency
1. Tax increase = takes $ from taxpayers & puts in govt. coffers.
2. Tax decrease = keeps $ with taxpayers & govt. has fewer funds.
3. Capital gains rate decreases stimulate investment?
4. Faster depreciation schedules force biz to replace machinery more often?
d. Administrability
1. Example: impact of borrowed funds on basis, gift rules.
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Chapter 2: What’s included in gross income?
I.
Included in Gross Income*
a. § 61(a) Gross income defined – all income from whatever source derived, including but not limited
to…
1. Glenshaw Glass – punitive damages are an accession to wealth, fully realized, over which
TP has complete dominion, so includable in gross income under § 61 (GI = big & broad).
2. § 61(a)(3) Gains derived from dealings in property included in GI.
3. § 1.61-1 GI = money, property, or services.
4. § 1.61-2(a) Wages, salaries, commissions, compensation for services, commissions on
insurance, tips, bonuses, severance pay… all included in GI.
5. § 1.61-2(d)(1) If services are paid for in property, FMV of property taken in payment must
be included in income as compensation.
6. § 1.61-2(d)(2)(i) Employer transfers property to employee/ind. contractor as compensation
for services for LESS THAN FMV, difference in value included in GI of employee/ind.
contractor.
i.
Example:
a. ER gives EE discount on clothing. EE buys 4K worth of clothing for cost of
1K.
b. This is the equivalent of ER paying EE for difference.
c. Therefore, 4K – 1K = 3K must be included in EE’s GI. m
ii.
If employee sells that property, AB = cost + difference
b. § 1001(a) Gain = AR – AB (realization requirement = triggering event, sale, exchange, disposition)
1. Example: Buy house for 150K & year later worth 250K. Does NOT sell = Unrealized 100K
increase in economic wealth.
c.
§ 1001(b) AR = money received + FMV of property received
1. Reg. 20.2031-1(b): FMV = price willing buyer pays willing seller, neither under
compulsion to buy/sell, both reasonable knowledge of relevant facts.
2. Example:
i.
Buy house for 150K & 10 years later worth 400K. Sells for FMV (400K cash) in Y10.
Want to avoid double taxation.
ii.
G = AR (money received + FMV) – AB (cost)
a. AR = 400K + 0
b. AB = 150K
c. G = 400K – 150K = 250K
iii.
Buyer gave seller house worth 400K or 150K cash and land worth 250K? Same
answer.
d. § 1011 See §§ 1012, 1016
e. § 1012 Basis of property = cost of property.
1. Basis includes “Tax cost basis” = basis TP has in property b/c must include value of
property received as payment for services/other property.
2. *Only have basis in property NOT services.
f. § 1016 Adjust basis for additional investment or cashing out of investment
Problems pg. 40-41 (1-3); 40-45 (2-4)
II.
Three Items NOT Included in Gross Income
a. True bargain = person gets good deal, benefit of bargain NOT included in GI.
1. Example: Buys paddleboard on sale for 500, regularly 1,500. The 1,000 savings is NOT
includable in GI.
2. Compare: Does 1,000 legal work for paddleboard company. Company offers paddleboard
that would retail for 1,500 for 500. Accepts.
i.
§ 1.61-2 compensation is included in GI.
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b. Imputed income = no GI when TP performs services for herself OR uses owned property w/out
paying herself rent.
3. Example: If owner rented it out, tenant pays 1,000/month. If owner uses it herself, she does
not pay herself rent.
4. Huge revenue loss in 2019 of not imputing income, but too difficult to administer. Also,
disparate impact among different populations.
c. First NW Industries
5. Issue: When can basis be subtracted?
6. Property must be sold or exchanged to allow for basis recovery.
III.
Tax Treatment of Debt
a. Old Colony Trust – third party relieving debt of TP does NOT allow TP to avoid taxes on that
income, payment of tax by employer on behalf of employee constitutes GI.
b. Loan proceeds = NOT included in GI b/c equal & offsetting obligation to repay & no deduction
when repaid. But see Kirby Lumber.
c. Kirby Lumber – if debt forgiven, discharged, or cancelled, it gives rise to GI = to amount debt
cancelled.
1. § 61(a)(12) Income from discharge of indebtedness INCLUDED in GI (Codified Kirby
Lumber).
2. Exceptions: § 108(a) Discharge of indebtedness NOT included in GI.
d. Recourse debt = Borrower doesn’t repay, lender has “full recourse” to come after whatever assets
borrower has.
e. Non-recourse debt = Borrower doesn’t repay, lender has no recourse to come after borrower’s
assets. Debt secured by the property itself & borrower’s only recourse is to foreclose on the property.
IV.
Impact of Debt on Basis
a. Equity = portion of property owned by owner w/out encumbrances (debt, liabilities, mortgage, etc.).
1. DIFFERENT than FMV b/c equity = FMV – encumbrances.
i.
Example: Kelly buys a car for $25,000 w/ cash and no loan.
a. Equity in car = FMV of car – encumbrance
b. = 25K – 0 = 25K.
ii.
Compare: Kelly buys a car for 25K. Borrows 20K from bank, 5K of his own cash.
a. Equity in the car = 25K – 20K = 5K.
2. DIFFERENT than gain b/c there’s no realization.
i.
Example: Buy house for 200K, mortgage 150K & pay 50K cash.
a. Equity = FMV– encumbrance
b. = 200K – 150K = 50K.
ii.
But, market forces increase value of house to 400K. No payment on debt, which is
still 150K.
a. Equity = FMV– encumbrance
b. = 400K – 150K = 250K.
b. Crane (recourse debt)
1. Good news!
i.
Rule: Debt is included in basis.
ii.
So, TP who borrows gets basis credit for debt he has yet to make.
a. Corollary rule: Paying down principal on loan has no tax consequence on
basis or GI (doesn’t give rise to deduction).
iii.
Example:
a. Buy house for 400K, borrowed 300K & 100K cash.
i. Debt is included in basis = 400K
b. Sells for 500K next year w/out paying on loan.
i. G = AR 500K – AB 400K (b/c debt included in basis) = 100K
2. Bad news.
i.
Rule: Relief from debt is included in Amount Realized.
ii.
Example:
a. Buy house for 400K, borrowed 300K & 100K cash.
b. Sells to buyer who pays 200K cash & takes property subject to mortgage.
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c.
c.
G = AR – AB
i. AR = Cash + FMV property received + DEBT RELIEF
1. 200K + 300K (buyer took mortgage) = 500K
ii. AB = 400 (debt included in basis)
iii. G = 500K – 400K = 100K
Tufts (non-recourse debt)
1. Rule: Debt STILL is included in basis.
Problems pg. 79-80 (1-4) STUDY THESE!
Chapter 3: What’s excluded from gross income?
V.
Gifts – think about DONOR and RECIPIENT!
b. § 102(a) GI does NOT include property acquired by gift, bequest, devise, or inheritance. Recipient
excludes value of gift from GI.
c. § 102(b) Exceptions:
1. Income from property in (a) ARE included in GI.
2. Where gift is of income from property, amount of such income IS included in GI.
d. § 102(c) Exceptions:
1. Gifts from employer to employee ARE included in GI.
e. § 1.102-1(f)(2) Exception to exception:
1. § 102(c) does NOT apply to amounts transferred between related parties if purpose
substantially attributed to familial relationship & NOT employment. So, family gifts NOT
included in GI.
f. Policy on Gifts: We want to encourage gift-giving & administrability. BUT perpetuates dynastic
wealth.
g. Duberstein – gifts are transfers made out of “detached and disinterested generosity.” Must look at
transferor’s intent, NOT what transferor calls the transfer (substance over form).
Problems pg. 94-95 (1-9)
VI.
Basis in Property Received by Gift - INTERVIVOS
a. § 1015(a) Gifts made after 12/31/1920.
1. General Rule: Basis = same as donor’s basis (carryover/transferred/substituted basis)
2. Exception: If donor’s basis greater than FMV at time of gift, then Basis = FMV.
b. Taft v. Bowers – Donor buys stock for 1K. Gives stock to recipient when FMV was 2K. Recipient
sells for 5K.
3. G = AR – AB
4. AR = 5K
5. AB = same as donor’s basis (carryover) = 1K
6. G = 5K – 1K = 4K
c.
Intervivos gift of property INCREASES in value? Good news:
7. No trigger of gain to donor on making gift (non-recognition) & recipient has no GI (will
have gain when disposes of property).
8. Example: D is in the 40% bracket, N is in the 10%.
i.
D paid 10K for property.
ii.
D gives N property when it’s worth 110K.
iii.
G = AR – AB = 110K – 10K = 100K of “built in gains”
a. If D sold, he would pay 40% x 100K = 40K
b. N sells, he pays 10% of 100K = 10K
i. Giving to N, less tax is paid on sale.
9. What does the GR for built-in gain property do?
i.
Allows for successful shift of income so that less tax is paid.
d. Intervivos gift of property DECREASES in value?
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10. Scenarios:
i.
Property that initially stayed the same or increased in value and later decreased in
value after time of gift, versus
ii.
Property that decreased in value from the time donor acquired it, prior to time of
the gift.
11. Example #1: D paid 10K for property, gives to N when worth 110K but value plummets
after gift to 8K.
i.
General Rule: AB = same as donor’s basis (carryover)
12. Example #2: D paid 10K for property. Value decreases while he owns it & gives to Noah
when worth 8K.
i.
Exception: If donor’s basis greater than FMV at time of gift, then Basis = FMV.
a. If N sells property at a loss, his AB = FMV.
b. If N sells property at a gain, his AB = same as donor’s basis (carryover)
13. Why the Exception for built-in loss property?
i.
Example: D is in the 10% bracket, N is in the 40%.
a. D pays 10K for property.
b. D gives N property when worth 8K at time of gift.
c. G = AR – AB = 8K – 10K = (2K)
i. If D sold, he would pay 10% x (2K) = (200)
ii. N sells, he pays 40% of (2K) = (800)
1. N able to take loss at higher bracket and value of loss
increases.
ii.
Exception prevents the shifting of the loss.
h. No Man’s Land
1. If property was built-in loss property (donor’s basis > FMV) at time of gift &
2. Was subsequently sold for AR in between FMV at time of gift & donor’s original basis…
3. THERE IS NO GAIN OR LOSS!
Problems pg. 104 (1-4)
VII.
Part Gift/Part Sale
a. How to identify PG/PS: Less than full & adequate consideration? Donative intent for remaining
interest?
b. § 1.1001-1(e) Tax consequences to DONOR’s basis (Dad’s gain)
1. G = to extent AR > AB, but no loss shall be realized.
c. § 1.1015-4 Tax consequences to RECIPIENT’s basis (Son’s gain)
1. AB = greater of (a) amount paid by recipient; or (b) carryover basis from donor.
d. Example: Dad buys stock for 25K. When worth 100K gives to son in exchange for 25K cash from son.
This is like dad sold 25K worth of stock for FMV & then gave remaining 75K as gift.
1. § 1.110-1(e)
i.
G = to extent AR > AB, but no loss shall be realized.
ii.
= 25K is not > 25K, so no gain OR loss.
2. Compare: 40K cash from son for stock?
i.
G = 40K > 25K, so G = 15K
e.
Example continued: Son sells for 100K the next day after gift.
1. § 1.1015-4
i.
AB = greater of (a) amount paid by recipient [25K]; or (b) carryover basis from donor
[25K].
ii.
G = AR – AB
iii.
= 100K – 25K = 75K
2. Compare: 40K cash from son for stock?
i.
AB = greater of 40K OR 25K
ii.
G = 100K – 40K = 60K
Page 5 of 19
VIII.
Basis in Property Received by Gift – TESTAMENTARY
a. § 1014(a) Basis in property acquired from decedent = FMV at date of death.
a. Stepped UP basis if property value increases while decedent owned it.
b. Stepped DOWN basis if property value decreases while decedent owned it.
i. SO ALWAYS SELL PROPERTY PRIOR TO DEATH! Unless sentimental value, etc.
c. Example: Grandma pays 100 for property, gives K property when worth 500.
i. At G’s death:
1. K’s basis stepped up to FMV of 500.
ii. K sells for 500:
1. G = AR – AB
2. G = 500 – 500 = 0
a. Biggest loophole in the tax code. Built-in gain goes untaxed if
transferred at death!
Problems pg. 104 (1-2)
b. § 1014(e) For sneaky sneak tricksters.
a. Rule: Donor gives gift → Decedent dies w/in 1 year → Back to original donor (or spouse) =
AB to original donor will be limited to AB of decedent immediately before death.
b. Example #1: E bought stock for 50. E knows Grandma going to die soon. E gives G stock
when worth 600K.
i. General Rule: Basis = same as donor’s basis (carryover/transferred/substituted
basis)
ii. So, Grandma’s AB = 50.
iii. Then G dies one month later, leaves stock to E in will.
iv. E is a trickster and thinks:
1. § 1014(a) General Rule: Basis in property acquired from decedent = FMV at
date of death = 600K.
v. But nope:
1. § 1014(e): AB to original donor will be limited to AB of decedent immediately
before death.
2. = Grandma’s AB right before death = 50.
c.
Compare Example #2: Same facts but instead of going back to original donor E, goes to E’s
child.
i. § 1014(e) does NOT apply. E’s child gets the stepped-up basis = FMV = 600K.
ii. Broke the circle & made a triangle.
Problems pg. 110
IX.
Transfers between Spouses/Former Spouse & Divorce
a. § 1041(a) Transferor = NO gain or loss. Transfer itself is non-recognition event.
b. § 1041(b) Transferee = AB = AB of transferor (carryover basis).
c. Example: S1 sells land (FMV 100K, AB 25K) to S2 for FMV.
1. Transferor S1 = NO gain or loss.
2. Transferee S2 = AB = AB of transferor.
i.
= 25K (S2 does NOT get stepped-up basis of 100K).
d. Divorce Example:
1. H & W divorce. The marital estate has one asset, a house worth 500,000, they purchased
for 100K.
i.
Equity = 400,000. Must be split by H & W.
ii.
W wants to stay in house, must pay 200K to H.
iii.
§ 1041 applies – no G to H, but also no increase in AB for W.
Problems pg. 108
Page 6 of 19
X.
Scholarships and Awards
e. § 74(a) Gross income INCLUDES prizes & awards.
1. § 74(b) Exception: GI does NOT include prizes & awards received in recognition of
religious, charitable, scientific, educational, artistic, literary, or civic achievement.
2. § 74(c) Exception: GI does NOT include employee achievement awards.
3. § 74(d) Exception: GI does NOT include Olympic medals. Lol.
f. § 117(a) GI does NOT include qualified scholarships received by an individual who’s a candidate for
a degree at an educational org.
1. § 117(b) QS = used for tuition & related expenses.
2. § 117(c) Exclusion does NOT cover amounts received as payment for teaching, research,
services required as a condition for getting QS.
3. § 117(d) GI does NOT include qualified tuition reductions. QTR = amounts for reductions
to employee of org. for education (below graduate level) at org.
Problems pg. 133 (1-4)
XI.
Damages
g. § 61(a) Gross income defined – all income from whatever source derived, including but not limited
to…
1. Glenshaw Glass – punitive damages are an accession to wealth, fully realized, over which
TP has complete dominion, so includable in gross income under § 61 (GI = big & broad).
2. So, generally, recoveries from litigation are included in GI.
h. § 104(a)(2) GI does NOT include damages (other than punitive) received by suit/agreement on
account of PHYSICAL injuries or sickness.
1. RULE #1: Flush language: Emotional Distress does NOT constitute physical
injury/sickness. (ED is only personal injury).
2. § 1.104-1(c)(2) Damages = recovered from tort-type action or statutory cause of action.
NOT fee for services (karate instructor charges for lessons, arm broken by student).
3. Punitive damages ALWAYS included in GI.
i. But ED damages CAN be excluded from GI if:
1. RULE #2: If ED caused by a personal physical injury or physical sickness:
i.
§ 1.104-1(c)(1). “Emotional distress is not considered a physical injury or physical
sickness. However, damages for emotional distress attributable to a physical injury
or physical sickness ARE excluded from income under 104(a)(2).”
2. (NOT on exam) RULE #3: Amount paid for medical care attributable to emotional
distress:
i.
§ 104(a) Flush language: Emotional Distress does NOT constitute physical
injury/sickness. BUT amount equal to medical expenses paid for ED is excludable.
ii.
§ 213 TP can only take § 104(a) deductions if TP has not taken any prior deductions
for the medical expenses.
iii.
Domeny – ED from hostile work environment exacerbated MS symptoms. Yes,
severe enough to constitute PI/PS & her damages were excludable from GI.
iv.
Parkinson – ED from hostile work environment caused heart attack. Yes, severe
enough to constitute PI/PS & her damages were excludable from GI.
v.
Blackwood – ED exacerbated depression symptoms. No, NOT severe enough. This
was just symptoms of ED, not a PI/PS.
j. Issues with § 104(a)(2): Damages for claims arising from discrimination/libel are all included in GI.
Problems pg. 142
Chapter 4: What is deductible from gross income?
I.
Business Deductions
a. BIG PICTURE:
1. Taxable Income = Gross Income – Deductions
i.
First Question: What’s included in Gross Income? GI = all income less excluded
things (first 3 chapters)
Page 7 of 19
2. Net Income = GI – expenses to produce that income
i.
Second Question: What is deductible from GI/what reduces GI?
II.
Expenditures – 4 distinctions between types:
a. Personal vs. Business/profit-seeking expenses
1. § 162(a) Deductions allowed for ordinary & necessary expenses in carrying on TOB.
2. § 262(a) Deductions NOT allowed for personal expenses.
3. Amend – Amend Co. reimbursed Christian Science dude Halverstadt who gave Mr. Amend
consultation on biz. Holding: expenses personal in nature.
4. Cavanaugh – dude took gf, gf died b/c overdosed on drugs given to her by dude’s
bodyguard. Holding: Expenses associated with lawsuit were personal in nature.
Questions pp. 156-57; 191
b. Ordinary vs. Extraordinary (capital) expenditures
1. § 162(a) Deductions allowed for ordinary & necessary expenses in carrying on TOB.
2. § 263(a) Deductions NOT allowed for extraordinary capital expenditures (amounts paid
for new buildings/permanent improvements/betterments that increase value of property).
These must be capitalized.
3. § 167 Deductions are allowed for the exhaustion, wear & tear, and obsolescence of property
used in a TOB or property held for the production of income.
4. § 168 Tangible property deductions under 167 are determined by using the applicable
depreciation method, recovery period, and convention. SEE DETAILS pg. 181-183.
5. Welch
i.
Rule:
a. Ordinary = strain of constancy w/in it, still variable & affected by
time/place/circumstance.
b. Necessary = appropriate & helpful.
ii.
Holding: Welch’s payments to creditors of defunct corporation to reestablish relations
& improve biz reputation in start-up were extraordinary (capital) & must be
capitalized.
6. Jenkins
i.
Rule: To determine whether payments deductible (ordinary):
a. Ascertain purpose/motive of TP in making payments &
b. Determine whether expenditures connected to TP’s TOB.
ii.
Holding: Conway Twitty’s payments to creditors of defunct corporation to protect his
reputation in ONGOING business were ordinary.
Questions pp. 152-53; 169
c. TOB vs. Profit-seeking expenditures
1. Groetzinger – TP spent 60 hrs./week dog racing & no other employment engaged in TOB
of professional gambler.
2. Higgins – TP was an investor, but “mere investors” holding property for investment are
not engaged in a TOB. Dealers/traders ARE engaged in TOB. So, TP could not deduct
expenses.
3. § 212 If individual, deductions allowed for ordinary & necessary expense paid or incurred
for:
i.
Production of income.
ii.
Mgmt., conservation, maintenance of prop. held for production of income.
iii.
Determination, collection, refund of tax.
4. § 212 not as good as § 162 – NOT on exam!
i.
Subject to 2% floor/haircut (never get entire amount)
ii.
If TP doesn’t itemize, doesn’t get benefit of 212
iii.
Under TCJA, misc itemized deductions under 212 disallowed through 2025
a. BUT, if the expenses incurred in renting property or licensing property, then
afforded same treatment under 162. See 62(a)(4).
Page 8 of 19
Questions pp. 172
d. COGS vs. Business expenses
1. Public Policy:
i.
§ 162(a) Deductions allowed for ordinary & necessary expenses in carrying on TOB…
UNLESS it would violate public policy:
ii.
§ 162(c) NO deductions for bribes, kickbacks, illegal payments.
iii.
§ 162(f) NO deductions for fines, penalties, violations of law.
iv.
§ 162(g) NO deductions for treble damages paid for antitrust violations.
v.
§ 162(q) TCJA NO deductions for payments related to sexual harassment & sexual
abuse (settlements, attorneys fees).
a. NDA in settlement (victim must keep quiet about suit)?
i. Payor/victim CANNOT deduct.
b. NO NDA in settlement (victim can speak publicly about suit)?
i. Payor/victim CAN deduct.
2. Marijuana:
i.
Edmondson – dude sold drugs, claimed O&N expenses.
ii.
Sullivan – TP eligible for O&N even though carrying on business that’s illegal.
iii.
§ 280E NO deduction for COTOB if TOB is trafficking in controlled substances.
iv.
CHAMP – 280E allows deductions for caregiving business but NOT sector of biz
selling medical marijuana.
v.
Olive – 280E does NOT allow deductions for selling medical marijuana.
vi.
MJ biz: Biggest cost is the goods.
a. 280E may prevent deductions TOB expenses but…
b. Can still reduce GI b/c GI = Gross receipts – cost of goods sold (COGS)
vii.
POLICY: GOOD ONE FOR POLICY QUESTION!
a. MJ businesses are taxed on gross income, not net. (assume 40% flat)
i. 1,000,000 in GI (having already reduced COGS) and 300,000 in O&N
expenses that are disallowed
ii. Amount in TP’s pocket = 700,000
iii. Tax = 40% x GI or 40% of 1,000,000 = $400,000 in tax
b. Businesses other than those trafficking in controlled substances are taxed on
net income.
i. 1,000,000 in GI (already reduced for COGS) and 300,000 O&N
expenses allowed = 700,000 net income
ii. Amount in TP’s pocket = 700,000
iii. Tax = 40% of Net income or 40% of 700,000 = $280,000 in tax.
c. MJ businesses are at a competitive disadvantage, do not get the same benefits
as other businesses in terms of reducing profit. They are taxed more.
d. Violates horizontal equity: Similar taxpayers with 700,000 profit are taxed
differently.
e. Effective rate for MJ = 57.14%
III.
Reasonable Salaries
a. § 162(a)(1) Deductions allowed for ordinary & necessary expenses in carrying on TOB including
SALARIES.
1. Issues only arise in closely-held corporations or in excessive compensation cases.
Page 9 of 19
b. Corporations:
Dividends – “double tax”:
Income to
Corp
Salary – single tax:
Income to
Corp
•$100
•$100
Corporation
Corporation
Pays tax
Salary of $100 ,
reduces net
income
•@40% = $40
•Leaves Corp with $60
Dividend to
SH
Salary to
EE/SH
•$60 dividend
SH pays tax
on dividend
•Net income = GI - 162(a)(1)
•= 100 - 100 = $0
•@40% = $0 in tax
•@40% = $24
•Leaves SH with
$36
•$100
income
SH pays tax
on income
•@40% = $40
•Leaves SH with $60
c.
Example:
1. Individual rate 20% & corp. rate 40% = prefer to reduce corp. income by paying huge salary
to SH.
2. Individual rate 40% & corp. rate 20% = prefer to draw minimal salary & keep wealth in
corp. for later date. *This is the current TCJA reality.
d. Exacto Springs
1. Issue: what is a “reasonable” salary?
2. Rule: what would independent investor expect as an ROI?
e. Intl. Freighting – TP (corp.) could take deduction on increased market value of shares b/c
reasonable compensation for services actually rendered. TP lost the higher value in assets. But, TP
also realized gain b/c disposition of assets for valid consideration equal to market value of shares.
Chapter 5: Business Deductions – Capital recovery, Depreciation, & Deductible Losses
I.
Identification of Capital Expenditures
a. § 162(a) DEDUCTIONS allowed for ordinary & necessary expenses in carrying on TOB.
b. § 263(a) Deductions NOT allowed for extraordinary capital expenditures. These must be
CAPITALIZED.
1. Capital expenditures
i.
Money spent on an asset that will earn money over a long period of time & are
expected to produce longer lasting benefit to the business.
ii.
E.g., amounts paid for new buildings/permanent improvements/betterments that
increase value of property.
2. Example: Orange Street Food Farm
i.
COGS = inventory (cost recovery = offsets gross receipts to arrive at: GI = gross
receipts – COGS).
ii.
Ordinary expenses = wages, utilities, phone bill, bleach, etc.
iii.
Capital expenses = shelves, furniture, goodwill, equipment, building itself, parking
lot, land.
c. § 1.263(a)-1 general rules, roadmap for regs, safe harbors.
d. § 1.263(a)-5 miscellaneous rules, amounts to acquire a TOB or to change capital structure.
e. THREE WAYS TO RECOVER CAPITAL EXPENDITURES
1. NON-depreciable assets
i.
LAND!
ii.
Recover cost when sold
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iii.
G = AR – AB
2. Depreciable TANGIBLE assets
i.
§ 1.263(a)
a. -2 amounts paid to ACQUIRE/PRODUCE tangible property
i. (d)(1) TP must capitalize amounts paid to acquire/produce unit of
real or personal property, including leasehold improvements, land
and land improvements, buildings, machinery, equipment, furniture,
fixtures.
ii. (e) TP must capitalize amounts paid to defend or protect title.
iii. (f) TP must capitalize amounts paid to facilitate acquisition of
real or personal property (transaction costs).
b. -3 amounts paid to IMPROVE tangible property (vs. repairs = deductible)
i. (d)(1) TP must capitalize amounts paid for BETTERMENTS:
1. (j)(i) Fixing a defect that previously existed or arose during
the TP’s production of property.
a. Example: TP pays for energy efficient upgrades to
building like replacing windows & adding insulation.
2. (j)(ii) Material addition, enlargement, expansion, extension.
a. Example: TP pays to convert part of building into
space for retail sales.
3. (j)(iii) Reasonably expected to materially increase
productivity, efficiency, strength, quality.
a. Example: TP pays monthly cleaning services and
handy person to inspect machinery and replace minor
parts.
ii. (d)(2) TP must capitalize amounts paid for RESTORATIONS:
1. (k)(iv) Return property to its ordinarily efficient operation.
a. Example: TP buys beat-up vintage trailer to renovate
as outdoor bar for tap room.
b. (Cf. deductible repairs that maintain ordinarily
efficient operating condition!)
iii. (d)(3) TP must capitalize amounts paid for ADAPTATIONS:
1. (l)(1) conversion of property to use that is not consistent with
TP’s ordinary use at time originally placed in service by TP.
a. Example: TP pays to convert manufacturing space
into retail space.
iv. (e)(2) each building & components is a single unit of property.
v. (i) safe harbor for routine maintenance on property
1. RM = keeps property in its ordinarily efficient operating
condition.
2. E.g., inspections, cleaning, testing, replacing damaged &
worn-out parts.
3. Depreciable INTANGIBLE assets
i.
§ 1.263(a)
a. -4 amounts paid to ACQUIRE/CREATE INtangible property
i. (c) TP must capitalize amounts paid to ACQUIRE intangible
property from another part.
1. (i)-(xv) Goodwill, leases, contracts, IP, customer lists,
software, financial interests, contract rights.
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ii. (d) TP must capitalize amounts paid to CREATE intangible property
from another part.
1. (2)-(9) Financial interests, contract rights, prepaid expenses,
memberships.
iii. (f) TP is NOT required to capitalize amounts paid to create any right
or benefit for TP that does not extend beyond the earlier of:
1. (i) 12 months after first date on which TP realizes
right/benefit; OR
2. (ii) the end of the taxable year following the taxable year in
which payment is made.
f.
Indopco – Holding: expenditures on legal & tax advice from bank & law firm produced long term
benefit & must be capitalized.
g. ADVERTISING? property rights or not
II.
Depreciation of Real & Personal Tangible Property ORAL EXAM!
a. WAYS TO RECOVER COST:
1. Gains derived from dealings in property:
i.
§ 61(a)(3) Gains derived from dealings in property included in GI.
ii.
§ 1001(a) Gain = AR – AB (realization requirement = triggering event, sale,
exchange, disposition)
iii.
§ 1012 Basis of property = cost
iv.
Recover basis in land when sold.
2. COGS:
i.
GI = Gross receipts – cost of goods sold
ii.
Recover COGS when sold.
3. DEPRECIATION!
i.
Economic concept = decline in value b/c wear & tear, exhaustion, obsolescence (drive
new car off lot).
ii.
Tax concept = allow TP to recover capitalized cost of asset over certain period of
time.
b. WHAT is depreciable? General Rule:
1. § 167(a) TP can take a depreciation deduction for the exhaustion, wear & tear, or
obsolescence of property used in the TOB or held for the production of income.
2. § 1-167(a)-(2) Depreciation allowance applies to:
i.
Tangible property = part of property that’s subject to wear & tear/obsolescence.
ii.
NOT:
a. Inventories (stock/trade) – these are intangible, don’t suffer exhaustion!
b. Land (except improvements to it)
c. Depletion of natural resources
d. Automobiles used for pleasure
e. Personal residence & stuff in it
i. Exception to exception: Properties & costumes used in business CAN
be depreciated
c.
How to CALCULATE depreciation amount:
1. Straight line depreciation
i.
SL = cost/recovery period (same deduction amount each year)
a. Example: 100K cost on 5-year property
i. 100K/5 = 20K depreciation/year = 20%
ii.
Easy to calculate… BUT NOT DONE THIS WAY b/c:
a. Property doesn’t wear out evenly.
i. Faster at first, slower later.
b. Cost recovery (accelerated depreciation) is a tool for economic
stimulus:
i. Net Income = GI – deductions
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iii.
ii. Deductions = O&N expenses + allowance for depreciation
1. Depreciation INCREASES deductions which…
2. DECREASES net income which…
3. DECREASES taxes for TP.
c. Example: If GI = 500K and O&N 162 expenses = 300K
i. Net Income = 500K – (300K + 0) = 200K x 20% flat tax rate = 40K tax
d. Example: If GI = 500K and O&N 162 expenses = 300K and annual
depreciation = 100K
i. Net Income = 500K – (300K + 100K) = 100K x 20% flat tax rate = 20K
tax = SAVINGS of 20K/year!
§ 168(b)(3) SL applies to NON-residential real property & residential rental
property.
2. Accelerated depreciation
i.
Front load deductions at the beginning of the recovery period & reduce over time.
ii.
§ 168(a) Plain Vanilla
a. Capital expenditure? (As opposed to O&N deductible expenses)
b. Depreciable property? (Suffers wear & tear, obsolescence in TOB/POI )
c. Depreciation deductions shall be determined by using the applicable:
i. METHOD = based on type of property
1. (b)(1) 200% declining balance method.
2. (b)(2) switch to SL in year SL gives greater deduction.
ii. RECOVERY PERIOD = given!
1. (c) See table on pg. 182 (always given in this class)
iii. CONVENTION
1. (d)(1) GR = half-year convention.
2. (d)(2) Real property = mid-month convention.
3. (d)(3) Substantial property placed into service during last 3
months of the year = mid-quarter convention.
iv. (e) Classification of property – See pg. 183
iii.
OVERALL STEPS:
a. Identify (1) METHOD; (2) RP; (3) CONVENTION; (4) Classification.
b. Look at Depreciation Tables.
i. Find correct table based on Convention, Classification.
ii. Find correct column based on RP.
iii. Find correct year in far left column (Y1, Y2, Y3…)
c. Depreciation Amount = Original Unreduced Basis x % from table
d. Example: On January 6, 2020, S buys and places into service new equipment
for his biz that cost 2,500,000. Equipment is 5-year property.
i. Method = 200% declining balance
ii. RP = 5 years
iii. Convention = half-year
iv. Table = 20% in Y1
v. Depreciable Amount = 2,500,000 x 20%
vi. = 500,000
iv.
How to figure out what basis will be in property in future years…
a. § 1016(a)(2) Proper adjustment of basis in property shall be made for
exhaustion, wear & tear, obsolescence, amortization, depletion…
i. AB = Original Unreduced Basis – Depreciation Amount Taken
b. Example cont.:
i. AB = 2,500,000 – 500,000
ii. = 2,000,000
v.
Dispose of property before recovery period ends? E.g., dispose of 5-year
property in Y3…
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a. Identify convention.
b. Look at Depreciation Tables.
i. Find correct table based on Convention, Classification.
ii. Find correct column based on RP.
iii. Find correct year in far left column (Y1, Y2, Y3…)
c. Depreciation Amount = Original Unreduced Basis x % from table
i. Take each amount for each of the years TP kept the property.
ii. BUT only entitled to ½ the amount for the year of disposition.
d. AB = Original Unreduced Basis – Depreciation Amount Taken
e. Example cont.:
i. Table:
1. 20% Y1 = 500,000
2. 32% Y2 = 800,000
3. 19.20% Y3 = 480,000
ii. If TP disposes of 5-year property in Y3…
1. Only entitled to ½ the amount for the year of disposition. So…
2. In Y3 TP takes ½ x 480,000 = 240,000
iii. AB = Original Unreduced Basis – [500K + 800K + 240K]
iv. = 2,500,000 – [1,540,000]
v. = 960,000
vi.
How to apply the exception for property placed into service during last 3
months of the TY (END-loading)…
a. Example: On December 6, 2020, S buys and places into service new
equipment for his biz that cost 2,500,000. Equipment is 5-year property.
i. Method = 200% declining balance
ii. RP = 5 years
iii. Convention = mid-quarter
iv. Table = 5% in Y1
b. Depreciation Amount = Original Unreduced Basis x % from table
i. = 2,500,000 x 5%
ii. = 125,000
c. AB = Original Unreduced Basis – Depreciation Amount Taken
i. = 2,500,000 – 125,000
ii. = 2,375,000
3. Bonus depreciation
i.
Allow extra percentage of depreciation as deduction in Y1.
ii.
§ 168(k)
a. (1)(A) For qualified property:
i. Depreciation deduction = applicable % x AB
b. (2)(A)
i. QP = property with a recovery period of 20 years or less.
ii. Original use begins with TP.
iii. Placed into service by TP before 1/1/2027.
c. (2)(B)
i. AB = Original Unreduced Basis – additional depreciation
allowance
d. (2)(E) property doesn’t have to be “new” if new to the TP.
e. (6) Applicable percentage – See pg. 192!
f. (7) TP can opt-out of bonus depreciation.
i. Why? Don’t have the $ in Y1, need to take depreciation later.
iii.
Example: On January 6, 2020, S buys and places into service new equipment for his
biz that cost 2,500,000. Equipment is 5-year property.
a. (2)(A) QP? Yes b/c:
i. RP 20 years or less
ii. Original use began w/ S.
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iii. Placed into service by TP before 1/1/2027.
b. (6) Applicable percentage = 100%
c. Depreciation deduction = applicable % x AB
i. = 100% x 2,5000,000
ii. = 2,500,000
d. AB = Original Unreduced Basis – additional depreciation allowance
i. = 2,5000,000 – 2,500,000
ii. = 0
4. Expensing
i.
Allow to take the entire cost in Y1 as deduction.
ii.
§ 179
a. (a) Treat cost of 179 property as a deductible expense.
b. (b)(1) deductible expense amount cannot exceed $1M .
c. (b)(2) reduces $1M limit if TP places property into service worth more than
$2.5M by amount by which cost exceeds 2.5M. Doesn’t go below 0, though.
d. (d) 179 property = tangible (NOT REAL) property or computer software
purchased for use in active conduct of TOB.
iii.
Example: On January 6, 2020, S buys and places into service new equipment for his
biz that cost 2,500,000. Equipment is 5-year property.
a. AB = 2,500,000 – 1,000,000 = 1,500,000
iv.
THEN APPLY § 168(k):
a. Depreciation deduction = applicable % x AB
i. = 100% x 1,500,000
ii. = 1,500,000
v.
Or, if TP opts out of 168(k)… APPLY 168(a):
a. Method = 200% declining balance
b. RP = 5 years
c. Convention = half-year
d. Table = 20% in Y1
e. Depreciation Amount = Original Unreduced Basis x % from table
f. = 1,500,000 x 20%
g. = 300,000
h. AB = Original Unreduced Basis – Depreciation Amount Taken
i. = 1,500,000 – 300,000
j. = 1,200,000
III.
Deductible Losses
a. § 165(a) TP can take a deduction for any loss sustained during the TY & not otherwise compensated
for by insurance or otherwise.
b. § 165(b) Basis for loss deduction = AB
c. § 165(c) Individual TP (as opposed to entity) can only take deduction if loss was:
1. Incurred in TOB
2. Incurred in for-profit transaction OR
3. Casualty losses (damage, destruction, loss of property because of an unexpected event like
fire, storm, shipwreck, theft, etc.)
d. § 1.165-1(b) TP can take deduction for losses if:
1. Evidenced by transactions/events &
2. Actually sustained (realized). When? 3 types of triggering events:
i.
Sale at a loss.
ii.
Theft on entire/partial portion of property.
iii.
Damage or otherwise causes property to become worthless.
e. § 1.165-1(d)(2)(i) TP can take deduction for casualty/other event in it occurs if:
1. TP makes a bonafide claim for recovery &
2. Has NO reasonable prospect of recovery.
i.
“Reasonable prospect” depends on facts & circumstances.
f. § 1.165-7(b) Deductible amount due to casualty is either:
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1. The adjusted basis OR
2. The difference in the property’s fair market value before and after damaging event,
3. Whichever is LESS.
g. PERSONAL losses:
1. § 262(a) NO deductions allowed for personal, living, or family expenses.
2. § 1.165-9 NO deductions allowed for loss on sale of residential property bought & used as
personal residence until sold.
h. RELATED taxpayers:
1. § 267
i.
(a) NO deduction allowed for loss on sale/exchange of property between…
ii.
(b)(1)-(13) family members, individual & corps. if individual owns more than half of
stock, two corps. of same group, etc. See pg. 268-269
iii.
(c) Constructive ownership of stock – family of individual includes ONLY brothers,
sisters, spouse, ancestors, lineal descendants.
i. Examples on PP of problems
Chapter 7: WHEN is the item included in GI or deducible from GI?
I.
Timing
a. Generally, TP wants to:
1. Defer income/inclusions/gains (Y2)
2. Accelerate deductions/losses/credits (Y1)
i.
*Except maybe if the TCJA gets repealed, might want to shelter income in the future because if
it gets repealed, rates will go back up. Thus, might want to save some deductions for later.
b. § 446
1. (a) Taxable Income computed under accounting method TP regularly uses to compute his
income in keeping his books.
2. (c) Permissible accounting methods (Given in this class):
i.
(1) Cash Method (individuals, small biz, sole proprietors, small partnership)
ii.
(2) Accrual Method (small business that elect, corporations, big partnerships)
c.
WHEN to INCLUDE item in GI:
1. Cash Method
i.
Physical receipt & actual payment.
ii.
§ 451(a) Any item of GI shall be included in GI for TY in which received by TP unless
amount properly accounted for in different period.
iii.
§ 1.451-1(a) Income included for TY in which actually OR constructively received.
iv.
Cash Equivalency Doctrine
a. Must include cash OR cash equivalent.
b. § 1.61-1(a) Income = any form = money, property, services.
c. Equivalent to cash:
i. Check
ii. Credit card, Venmo, PayPal, other e-payments
iii. Property (If has clear value, appears to be bargained-for
consideration).
iv. Services (Include value of services)
v. Negotiable note for full amt. of bill (Include FMV at time of receipt if
not is readily transferrable for ascertainable value).
d. NOT cash equivalent:
i. Letter IOU (This is just mere promise to pay, so NOT included in GI).
v.
Constructive Receipt
a. Constructive Receipt = credited to TP account, set apart for TP, or otherwise
made available so TP may draw upon it at any time.
b. NOT constructive receipt = where income is subject to substantial limitations
or restrictions.
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c.
Hornung – NFL gives MVP Hornung corvette prize. Only had notice of prize
on Dec. 31 & was in a different city. Hornung says had CR in Y1, but court
said Y2. Weird b/c TP wants to include in GI sooner rather than later – that’s
because of § 6501(a): 3-year SOL for IRS to assess additional tax. Here, 1965
TY. Hornung tried to argue for CR inclusion in 1961 so that it’d be timebarred.
2. Accrual Method
i.
Legal right to payment.
ii.
§ 1.451-1(a) Income included when all events have occurred that fix right to receive
income & amount can be determined w/ reasonable accuracy.
3. Example: D delivers 500 worth of beer to Rhino on Dec. 1, 2020 (Y1). Rhino pays her 500
cash on Jan. 1, 2021 (Y2). When does D include $500 in GI?
i.
Cash Method = Y2 b/c she received it in Y2.
ii.
Accrual Method = Y1 b/c she had a legal right to payment when she delivered the
beer in Y1 & amount can be determined in Y1 (500 cost).
d. WHEN an item is DEDUCTIBLE from GI:
1. § 461(a) Deduction/credit taken in TY which is the proper TY under accounting method.
2. Cash Method
i.
§1.461-1(a)(1) Deductions allowed in TY when paid.
3. Accrual Method
i.
§1.461-1(a)(2) Deductions allowed in TY when all events have occurred that
establish fact of liability, amount of liability can be determined w/ reasonable
accuracy, & economic performance has occurred.
a. Economic services = focus on performance of the recipient of payment.
e.
4. Example: L provides C w/ landscaping services in 2020 (Y1). L sends C bill for 1,000 on
Dec. 1, 2020. C pays cash on Jan. 5, 2021 (Y2). Landscaping services are deductible in
nature (as opposed to capital expenditures/personal expenses). When does C take
deduction?
i.
Cash Method = Y2 b/c C paid in Y2.
ii.
Accrual Method = Y1 b/c events fixing liability happened in Y1 (L did work), amount
can be determined in Y1 (L calculated bill), and econ. perf. happened in Y1 (L did
work).
***REMEMBER: capitalized expenditures are not deductible just by virtue of a method of
accounting, the timing rules do NOT grant the deduction or override the rules for cost recovery.
All the problems assigned, pp. 272-273
Chapter 8: What is the Character of the item of income/loss?
May all your gains be capital & all your losses be ordinary!
I.
Capital Gains & Losses – Disposition of property only!!!
a. § 1(h) GAINS
1. Top marginal rate = 37%
2. Top preferential rate = 20% & progressive 0/15/20
3. Difference of 17% if TP is in top marginal bracket!
b. § 1211 LOSSES
1. (a) Corporations: losses from sales/exchanges of capital assets shall be allowed only to
extent of gains from sales/exchanges of those capital assets.
2. (b) Other TPs: losses from sales/exchanges of capital assets shall be only to extent of gains
PLUS lower of
i.
3,000 OR
Page 17 of 19
c.
ii.
Excess of losses over gains.
§ 1221(a) Capital Asset = property held by the TP (whether or not for TOB).
1. But NOT: Stock in trade of TP or other property included in inventory, property held by TP
primarily for sale to customers in ordinary course of TOB, property used in TOB (subject to
§ 167 depreciation), self-created IP, accounts/notes receivable of TOB, publication of U.S.
govt., commodities, hedging transactions, supplies related to TOB.
2. Rice v. Comm’r – couple bought property & used some to build dream home, sold other lots
mainly to family & friends. Court said property was purchased as an investment NOT as
property held for customers in couple’s ordinary course of TOB (one of the 1221(a)
exceptions). Thus, couple entitled to capital gains treatment. *Look at nature of the
asset in the hands of the particular TP!*
d. WHY?
1. Policies FOR preferential rates for capital gains:
i.
Ameliorate bunching.
a. Bunching =
i. Consequence of realization rule.
ii. Increasing value occurring over multi-year period is all triggered for a
single year.
iii. Throws the same TI into a higher bracket.
ii.
Account for inflation.
a. Increase in value over a long period of time does not represent the true
appreciation in value (illusory gains).
iii.
Encourage investment in capital assets and liquidity in the market.
2. Policies AGAINST preferential rates for capital gains:
i.
Bunching can be fixed through multi-year spread of gains, nix realization, taxed
appraised values).
ii.
Horizontal equity problems (see Example below).
iii.
Increases complexity in the law, gamesmanship, & avoidance strategies.
e.
Example: GOOD ONE FOR POLICY QUESTION!
1. C earns 100,000 as lawyer and is in 40% tax bracket (actual highest is 37, using 40 for easy
calculation).
2. P sells capital asset she held for more than a year for gain of 100,000 and is in top
marginal bracket (so she’s in same bracket as C).
3. P’s gain on the capital asset = adjusted net capital gain. Therefore, her maximum capital
gains rate on the 100,000 = 20%.
i.
P = 20% x 100,000 = 20,000 in taxes owed
ii.
C = 40% x 100,000 = 40,000 in taxes owed
a. Horizontal equity problem! Sale of capital asset is given preferential
treatment to the same amount of money earned through labor.
Problems p. 307
Chapter 9: Who is the proper taxpayer?
I.
Who is the proper taxpayer?
a. Progressive rates = drive desire to shift income to lower-income taxpayers & avoid higher rates of
tax.
1. Example:
i.
L earns 1,000,000 @ 40% = 400,000 tax liability.
ii.
N earns 100,000 @ 20% = 20,000 tax liability
iii.
Cut off for 40% bracket = 600,000.
iv.
So, if L can shift (assign) income to N, cuts tax liability in half. L has
employer pay N 400,000 instead of paying her.
v.
Now…
a. L earns 600,000 @ 20% = 120,000
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vi.
vii.
b. N earns 500,000 (100K + 400K) @ 20% = 100,000
Total income STILL 1,100,000 but total tax is only 220,000. Reduced tax by
200,000 or 50%!
But, can’t do this b/c doctrine prohibiting assignment of income.
b. Two rules prohibiting assignment of income:
1. Income derived from services:
i.
Lucas v. Earl
a. RULE: Income earned is taxed to the TP who earns it.
b. Holding: TP husband is taxed on his whole salary. Half does not get
attributed to his wife b/c owned property JTWROS.
2. Income derived from property:
i.
Helvering v. Horst
a. RULE: Income earned is taxed to the TP who owns the property.
b. Holding: Bond owner gifted interest coupons. Realization of income is taxable
to donor b/c he was owner – had the principal & interest property rights.
Would have been different if he gave bond AND interest coupons.
c. Don’t forget connections with rules re: gifts, especially gifts of income interests!
1. § 102(a) GI does NOT include property acquired by gift, bequest, devise, or inheritance.
Recipient excludes value of gift from GI.
2. § 102(b) Exceptions:
i.
Income from property in (a) ARE included in GI.
ii.
Where gift is of income from property, amount of such income IS included in GI.
Problems p. 399-400
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